Doves vs. Hawks

The commodity currencies of Canada, Australia and New Zealand led the way higher in FX last week underpinned by firmer commodity prices and an improving China. The commodity futures price index, the CRB, has advanced for 8 weeks since putting in a double bottom in early February. China’s industrial output and retail sales surged in March urging greater confidence that China’s economy has stabilized and will avoid a hard landing. Of course, the better the Chinese economy performs the better the continued advance for commodity prices.

There were no less than eight Federal Reserve Presidents speaking last week. Some were doves, some were hawks, some were FOMC voting members, and some were not. One wanted a rate hike in April; others ruled out an April hike but favoured a June hike; and one (Lacker) was busy making a case for four rates hikes in 2016 – I kid you not. I don’t know about you, but methinks that continued pontification by US Fed members is starting to fall on deaf ears. I think the market is sensing this as well – US Fed fund futures is pricing in 2% chance of a rate hike at the April FOMC meeting, 13% for June, 28% for July, 36% for September, 40% for November, and 52% for December, 55% in February 2017. In other words, the market is pricing in no rate hike until 2017.

So with possible interest rate hikes being pushed out further in time, the USD continued to be shunned. U.S. economic reports didn’t help the dollar’s cause either. A horrible retail sales report and a disappointing inflation report undermined the US Fed’s interest rate hike expectations.

At the time of this writing, we learn that the world’s major oil producers failed to reach an agreement to freeze oil production at this weekend’s OPEC and non-OPEC meeting in Doha. No one should be surprised by this as, over a month ago, the Saudis stated that there would be no agreement without Iran’s participation. There was no way that Iran would agree to freeze production now that they have been allowed to sell oil again on the world market after agreeing to forgo their nuclear ambitions; and the Saudis knew this. The price of oil and the CAD have steadily gone up over the past two months on hopes of a deal.

CAD Casualty

The CAD was the main casualty of the USD’s reversal, falling 1.95% on the week, which ended a nine week rally. The possible culprits for the drop in the loonie were the slump in the price of oil and/or the release of the Canadian Federal Budget.

The world’s eyes were on Canada last week as it became the first major industrialized country to opt for fiscal stimulus rather than rely solely on monetary easing. The Organization for Economic Co-operation and Development and the International Monetary Fund has stressed the need for governments to turn to fiscal policies instead of monetary central bank policies; and the Canadian government delivered by promising to spend more on infrastructure to boost growth. The Canadian Finance Department estimates that the stimulus spending will drive 0.5% of GDP growth. The government is putting the bulk of its effort on the middle class and expecting a positive spillover to the rest of the economy. The bad news is that federal finances will go from a near-balanced position of the past two years to big budget deficits of almost $30 billion (or 1.5% of GDP) for each of the next two fiscal years. Canada’s pristine balance sheet will be affected in the short term but with the current global backdrop this will be acceptable. The key for the currency will be for the medium term – will the government be able to reverse the deficits down the road? We will come back to this point in four years’ time.

With the cumulative burden of big deficits down the road, the CAD was weighed down more by the combination of a firmer USD and the lower price of crude. The price of oil approached the 200-day moving average around the $42 level last week and backed off after U.S. crude inventories jumped more than expected and gasoline stockpiles fell. The Energy Information Administration reported U.S. crude stocks rose by 9.4 million barrels in the previous week to a record total of 532.5 million barrels. Offsetting the build was a 4.6 million barrel decline in gasoline inventories. The EIA also said weekly production ticked down by about 30,000 barrels per day. This spells trouble for oil and the CAD as inventories are at all-time highs nearing full capacity as we approach the spring maintenance season for refiners.

The USD/CAD rate has moved up through the overhead downward sloping trend line drawn off the mid January high. The technical indicators are also aligned with the up move in the rate with the RSI rising and with the crossover in the MACD. A move to the 200-day moving average would be constructive. Also, if the price of oil were to fall below the shelf carved out at just above the $36 level then the USD/CAD rate could attempt to reach the falling 50-day moving average.

During the previous week, the US Fed’s actions sent the USD reeling but that all changed last week as the USD climbed out of the basement to the top of the heap. The USD was well bid all week as nearly half of the regional Federal Reserve presidents appeared more willing to support rate hikes than was the impression following the previous week’s Fed meeting and press conference by Janet Yellen. Of course, this may have been an attempt by the Fed to steer markets away from their post-FOMC conclusion that the Fed was safely out of the picture for the next few months. Thus, the regional Fed presidents were successful at injecting some speculation about the appropriate number of rate hikes this year and adding some uncertainty about a possible hike in the April or June meetings. Any time a regional Fed president is a little more hawkish or less dovish it is USD supportive.

Meanwhile, the GBP was at the bottom of the heap following the release of soft inflation data and an increase in the odds of the UK leaving the European Union in the June referendum in the wake of the Brussels terror attacks. With immigration as a key issue in the referendum, the GBP was knocked down as traders presumed that British voters might seek to distance themselves from the EU and the terrorist attacks that took place first in Paris back in November and now in Brussels. The February inflation reading added to the GBP’s pain. The 0.3% reading is unchanged on the previous month and was below the forecast of 0.4%.

U.S. Interest rate hike finally has "Lift-Off"

Yesterday, The U.S. Federal Reserve raised the fed funds rate by 0.25% to 0.25% – 0.50%. The zero interest rate policy had been in effect for 7 years, ever since the Fed slashed its key rate by 0.75% back on Dec. 16, 2008. The immediate reaction to the announcement saw a quick burst of USD strength taking USDCAD from 1.3780 up to 1.3847 – the highest level since 2004. The move was short-lived and the USD saw some broad-based weakness after the press conference taking USDCAD down to 1.3740 before rebounding towards 1.3780. Although Federal Reserve Chair Janet Yellen is confident in the U.S. economic outlook, she emphasized that subsequent rate hikes would be gradual and data dependent. Looking at the Fed “Dot Plot”  there are some changes from the previous meeting:

2016 = 1.375% unchanged

2017 = 2.375% down from 2.625%

2018 = 3.25% down from 3.375%

Longer run = 3.5% unchanged

The USD has been rising steadily over the past 2 years in anticipation of interest rate “lift-off”. The divergence in central bank policies is expected to be a shorter-term trend as other central banks have recently switched from a dovish to a neutral stance. It will only be a matter of time before global interest rates follow the Fed’s lead. For this reason alone, yesterday’s rate hike and subsequent rate hikes may already  be priced into the market. Significant further gains in the USD may be limited. A recent foreign exchange poll from the major Canadian banks suggest that the USDCAD rate will peak in Q1 2016 and then trend lower over the balance of the year.

A quick snapshot of where we’ve been and where we are today:

Dec. 2005

Bank of Canada overnight target rate was 3.25%

U.S. Fed funds rate was 4.25%

WTI oil was trading at $59/ barrel

USDCAD held a 1.1425 – 1.1750 range

Dec. 2015

Bank of Canada overnight target rate is 0.50%

U.S. Fed funds rate is 0.25% - 0.50%

WTI oil trading at $35/ barrel

USDCAD trading in a 1.3280 – 1.3971 range

Steve Brown

Senior Corporate FX Trader

stevebrown@vbce.ca

USD Continues to Shine

The USD continued to shine during the American Thanksgiving holiday-thinned week. The market continued to bid the USD higher driving home the notion of monetary policy divergence between the U.S. Federal Reserve and other central banks. It appears that the market is fully pricing in the Fed’s first interest rate hike in nine years on December 16th. The divergence theme is set to be reinforced this week with the European Central Bank policy meeting on Thursday, where expectations are very high that the ECB is ready to act.

And this brings us to the reason why the Swiss franc was the weakest of the major currencies last week. The market is so convinced of an ECB move that it has sold off the CHF in anticipation that the Swiss National Bank will quickly follow any ECB action with one of its own at its next scheduled meeting is December 10. We don’t know about you, but our Spidey senses tingle when everything seems to be a foregone conclusion. As it stands right now, the market appears to be fully pricing in an ECB move and a Fed hike. In marketspeak – these are expectations that have been discounted by the market. Thus, with the majority of the market leaning the same way, it is entirely possible for a correction to ensue resulting from either disappointing ECB action or Fed hike uncertainty due to Friday’s U.S. jobs report.

One has to wonder if this week’s ECB meeting will be the catalyst for the change in trend. With the market currently priced for perfection, i.e. an ECB move, there is scope for disappointment. If ECB President Mario Draghi underwhelms expectations then a short squeeze will ensue. The question then becomes is this a shakeout that provides investors with a better position, or a swan song for the USD and the monetary divergence theme?

This coming week is one of the most important weeks of the year, which could set the stage for 2016. It’s a big week data-wise with the IMF’s approval of CNY inclusion in the SDR earlier today (see our blog post from Nov. 16, 2015) ISM manufacturing report on Tuesday, ISM service report on Wednesday, ECB decision on Thursday, and the jobs report on Friday. Let’s see where the price
action takes us.

United Nations of Debt

(From World Economic Forum)

For much of the year, investors have been fixated on when the Fed will achieve “liftoff” – that is, when it will raise interest rates by 25 basis points, or 0.25%, as a first step toward normalizing monetary conditions. Markets have soared and plummeted in response to small changes in Fed statements perceived as affecting the likelihood that liftoff is imminent.
But, in seeking to gauge changes in US monetary conditions, investors have been looking in the wrong place. Since mid-August, when Chinese policymakers startled the markets by devaluing the renminbi by 2%, China’s official intervention in foreign-exchange markets has continued, in order to prevent the currency from falling further. The Chinese authorities have been selling foreign securities, mainly United States Treasury bonds, and buying up renminbi.
This is the opposite of what China did when the renminbi was strong. Back then, China bought US Treasury bonds to keep the currency from rising and eroding the competitiveness of Chinese exporters. As a result, it accumulated an astounding $4 trillion of foreign reserves.

The effects of these purchases attracted considerable attention. In 2005, US Federal Reserve Chair Alan Greenspan pointed to the phenomenon as an explanation for his famous “conundrum”: interest rates on Treasury bonds were lower than market conditions appeared to warrant. His successor, Ben Bernanke, similarly pointed to purchases of US debt by foreign central banks and governments as a reason why American interest rates were so low.

Now this process has gone into reverse. Although no one outside official Chinese circles knows the exact magnitude of China’s foreign-exchange intervention, informed guesses suggest that it has been running at roughly $100 billion a month since mid-August. Observers believe that roughly 60% of China’s liquid reserves are in US Treasury bills. Given that reserve managers prefer to avoid unbalancing their carefully composed portfolios, they probably have been selling Treasuries at a rate of roughly $60 billion a month.

The effects are analogous – but opposite – to those of quantitative easing. Recall that the Fed began its third round of quantitative easing (QE3) by purchasing $40 billion of securities a month, before boosting the volume to $85 billion. Monthly sales of $60 billion by China’s government would lie squarely in the middle. Estimates of the effects of QE3 differ. But the weight of the evidence is that QE3 had a modest but significant downward impact on Treasury yields and a positive effect on demand for riskier assets.

Menzie Chinn of the University of Wisconsin has examined the impact of foreign purchases and sales of US government securities on ten-year Treasury yields. His estimates imply that foreign sales at a rate of $60 billion per month raise yields by ten basis points. Given that China has been at it for 2.5 months, this implies that the equivalent of a 25-basis-point increase in interest rates has already been injected into the market.

Some would object that the renminbi is weak because China is experiencing capital outflows by private investors, and that some of this private money also flows into US financial markets. This is technically correct, but it is already factored into the changes in interest rates described above. Recall that capital also flowed out of the US when the Fed was engaged in QE, without vitiating the effects. That was what the earlier debate over “currency wars” – when emerging markets complained about being inundated by financial inflows from the US – was all about.

Another objection is that QE operates not just through the so-called portfolio channel – by changing the mix of securities in the market – but also through the expectations channel. It signals that the authorities are seriously committed to making the future different from the past. But if Chinese intervention is just a one-off event, and there are no expectations of it continuing, then this second channel shouldn’t be operative, and the impact will be smaller than that of QE.

The problem is that no one knows how long capital outflows from China will persist or how long the Chinese authorities will continue to intervene. From this standpoint, the Fed’s decision to wait to begin liftoff is eminently sensible. And, given that China holds (and is therefore now selling) euros as well, the European Central Bank also should bear this in mind when it decides in December whether to ramp up its own program of quantitative easing.

Ok CAD!

The CAD turned in another strong performance after leading the pack the previous week, however, caution is warranted after last Friday’s employment report. Like all currencies, the CAD has benefited from the US Fed’s dovish September hold. Another driver of the CAD’s advance has been the rebound in the economy. Back-to-back monthly GDP growth in June and July after five sequential months of negative or zero growth has help to cement expectations that the economy may have turned the corner and would not need any additional easing by the Bank of Canada. Of course, a discussion on the performance of the CAD would not be complete without any mention of the price of crude. Crude oil has managed to rally about 34% of its recent low in August and also managed to rise over the $50 level this past week before giving up some of its gains. Having said this, the way forward for Canada remains bumpy as evidenced by Friday’s jobs data. Canada added 12.1k jobs in the month of September, which was slightly better than expected. However, all of those gains were in part-time jobs since there was a loss of 61.9k full-time jobs, the largest amount since October 2011. That brings the loss in full-time jobs to 25K for Q3 alone. In addition, the unemployment rate rose to 7.1%, a 2-year high. This type of data warns that the rally in the CAD may sputter soon.

For the second consecutive week the USD has been the underperformer against the majors as the release of the FOMC minutes from the September meeting reinforced the dovish impression. The leaders of the pack, AUD and NZD, each managed to turn in a 4% increase on the week, powered by its own unique driver. The AUD surged higher after the Reserve Bank of Australia kept rates on hold as expected but it suggested that the bar was high for another rate cut this year. For the NZD, the story continued to be milk. Milk prices increased for the fourth auction in a row, fanning expectations that prices for New Zealand’s most important export have bottomed, which in turn takes the pressure off the Reserve Bank of New Zealand to ease again.

We had no less than six FOMC members speaking last week and even though all 6 members are considered doves, they all went out of their way to impress upon us that an interest rate hike is coming soon and that they really, really, really mean it this time. Oh really?! They’re not the only ones trying to sell us this line. Apparently 64% of the economists surveyed by the Wall Street Journal expect a hike in December. To be a little fair, some of these economists have wavered from their original position because back in August, 82% expected a hike in September. The survey also found that 23% expect the first hike will be delivered in March 2016; do we hear anyone for 2017? We wonder if any of these economists are also employed at the IMF because they just downgraded global growth to 3.1% this year from its previous forecast of 3.3%. By the way, it was the fourth time this year that they changed their forecast. Are you kidding me? Why do we even listen to these people? Apparently, we are not the only ones with this opinion. Joris Luyendijk of the Guardian wrote an eloquent piece on the science of economics, or rather the lack thereof, this weekend titled, “Don’t let the Nobel prize fool you, Economics is not a science.”

We have our doubts. We don’t see a hike at all this year or next, which falls in line with many forecasters and analysts. But hey… what do we know? We’re not going to let the fact that for the first time since 2009, all six major Fed regional activity surveys are in contraction territory. We’re also going to ignore the fact that 3-month bills sold at a yield of zero for the first time in history. That’s right, at last Monday’s Treasury auction investors decided to buy $21 billion in 3-month Treasury bills at a yield of zero. If that didn’t astonish you, demand was the strongest in over three months, as the bid-to-cover ratio, which is a widely used measure of demand, was the highest since late June, according to data from Jefferies. Don’t worry folks, interest rates can’t go much lower than zero, or can they?

The USD has been the worst performing currency since the Fed decided to leave interest rate on hold at its September policy meeting. This weakening in the USD combined with the global slowdown in growth and lower inflation due to lower commodity prices is starting to undermine the current quantitative easing (QE) programs of the ECB and the BOJ. What we mean by undermine is that the euro and yen are rising against the USD. This may cause these central banks along with other foreign central banks to ease policy even further causing the USD to rise again. If this transpires, then the Fed may have to respond in kind in order to keep the USD in check (The ECB and BOJ can’t have this, there is a currency war going on after all). Many of the bloggers in cyberspace that are calling for QE4 have it all wrong. The fact that we have had more than one QE program from the Fed only tells us that they have all failed. We think the Fed’s next move will be not a hike in rates or another QE program, but a cut in interest rates to negative. Don’t think it’s possible? Well, let’s consider that the Swiss national bank is at negative 0.75%, the ECB is at negative 0.20%, and Sweden and Denmark are also in negative territory. Also, remember the September dot plot, which showed that one FOMC member wanted negative rates at the end of 2015 and 2016. We’re guessing that was Minneapolis Fed chief Narayana Kocherlakota because in a speech last Thursday he made these following points that were summarized by Bloomberg:

 KOCHERLAKOTA SAYS FED SHOULD CONSIDER NEGATIVE RATES
 KOCHERLAKOTA: TAPERING ASSET PURCHASES LED TO SLOWER JOB GAINS
 KOCHERLAKOTA SAYS JOBS SLOWDOWN 'NOT SURPRISING' GIVEN POLICY
 KOCHERLAKOTA: TAPERING ASSET PURCHASES LED TO SLOWER JOB GAINS

We would be remised if we didn’t mention the China factor in all of this. China’s foreign exchange reserves fell another $43bn last month, suggesting continued intervention in the forex markets to support the renminbi. This was down from the $94bn they spent in August trying to shore up the renminbi after the August 11 devaluation. Should we expect the Chinese to continue to spend their reserves on stopping their currency from falling while their economy continues to sputter? Wouldn’t it help China’s economy if they allowed the currency to fall? We suspect that if the Chinese renminbi does fall it will force the Fed to react and that reaction may very well be in the form of negative interest rates.

The Big Tickle

All currencies rallied to the upside against the USD last week except for the euro after the Federal Reserve switched gears. The best performs were the commodity cousins, the aussie and kiwi, in the wake of the Fed’s indecision on an interest rate hike. The euro unwound its post-Fed rally the following day after European Central Bank policy makers noted risks to the global economy. Benoit Coeure, an ECB Executive Board member, said the Fed’s decision vindicates the ECB’s assessment of the uncertainties surrounding the global growth outlook while his colleague on the ECB board, Peter Praet, said in an interview with the NZZ newspaper that the ECB should be ready to act if economic shocks turn out to be long-lasting.

The big tickle for the week was the Fed’s policy shift. Most were probably not surprised that the Fed left rates unchanged at their FOMC meeting last week. That makes it 55 straight meetings without a change in interest rates. The surprise came in the Fed’s reasoning for its inaction – its concerns that developments in the global economy and markets could “restrain US economic activity somewhat”. This change emphasizes that global growth concerns are a real concern, which may cause a risk off environment to develop.

We guess we can call this move a “dovish hold”.

The Fed also released its dot plot plan after the meeting. The plot shows the projections of the 16 members of the Federal Open Market Committee (the rate-setting body within the Fed). Each dot represents a member’s view on where the fed funds rate should be at the end of the various calendar years shown. The latest plot reveals the number of policy makers who do not expect lift-off to happen in 2015 has risen from two to four. Thus, 13 of 17 Fed officials still expect a rate hike this year, which is down from 15 in the June plot. This is surprising considering the new wrinkle towards global growth uncertainty – if the Fed is now “officially” worried about the recent global growth uncertainty is it logical that two months of global data will be enough to alleviate that uncertainty so that they can raise interest rates at their December meeting?

There was yet another shocker in the dot plot. For the first time ever, one Fed policy maker is forecasting negative rates for this year and next (highlighted in red on the dot plot). During the post meeting press conference, Chair Yellen was asked about negative rates and she said that negative rates were not "something we seriously considered" at the current juncture. However, she didn't rule it out – “I don’t expect that we’re going to be in a path of providing additional accommodation. But if the outlook were to change in a way that most of my colleagues and I do not expect, and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools. And that would be something that we would evaluate in that kind of context.”

The implications from all of this are that other foreign central bankers may be forced into further action. With the Fed on hold, dovish central banks may want to ensure that the Fed’s inaction doesn't jeopardize their own domestic inflation targets – thereby setting off another round of monetary easing in the ongoing currency wars.

Why the Fed HAS to Consider the Global Economy

From CNBC found here.

Operating within an economic system where the foreign trade sector represents nearly one-third of demand and output, the Fed must carefully consider price and activity effects coming from the rest of the world. This year, for example, an estimated foreign trade deficit of more than $500 billion is expected to reduce America's economic growth by an entire percentage point. That is because the strong domestic demand – consisting of private consumption, residential investments, business capital outlays and public spending - is stimulating the purchases of foreign goods and services, while the weak economies in the rest of the world, and a strong dollar, are holding back American export sales.

External price effects on American inflation developments are equally strong and straightforward. Driven by a 13.3 percent decline in fuel costs, import prices in the year to August fell 11.4 percent. The non-fuel prices also declined 3 percent, marking their largest drop since October 2009. As a result of that, the headline index of consumer prices (CPI) rose only 0.2 percent in the twelve months to August. But, over the same period, price gains in sectors sheltered from international competition – approximated by the core CPI - edged up 1.8 percent, maintaining the rate of increase observed since the middle of last year.

That enormous difference between the headline and the core rates of inflation shows the strength of externally-induced effects on American costs and prices. And the U.S. inflation story does not end there. What was discussed so far are just the first-round external effects on the domestic price formation process. The second-round effects are arguably even stronger and more pervasive, because an open trading system and declining import prices exercise a vigorous restraint on the pricing power in a broad range of American industries. All this shows how America's foreign trade transactions directly impact the Fed's ability to fulfil its mandate of full employment and price stability.

Employment, in particular, is a difficult part of the mandate. Monetarists have often objected to that. They argue that the monetary policy can only provide an environment of price stability in which demand, output and employment creation can take place. But the mandate is still there, and employment is always a politically-charged issue. Consider, for example, the fact that the current labor market numbers are not as good as implied by the reported 5.1 percent unemployment rate.
Adding 6.5 million involuntary part-time workers (people working part-time because they cannot get a full-time job) and 1.8 million people who are marginally attached to the labor force (mainly people who quit looking for a job because they could not find one), gives an actual unemployment rate that is more than double the official 5.1 percent rate. That also means that the actual number of unemployed is 16.3 million, rather than the reported 8 million. The high numbers of America's long-term unemployed (people out of work for 27 months and over) are reflecting current labor market difficulties as well. These numbers have been increasing since last June to reach 2.2 million at the end of August, accounting for nearly one-third of the reported unemployment.

A similar note about America's soft labor markets is sounded by average hourly earnings; they were roughly unchanged over the three months to August. Now, let's bring back into discussion that 1 percentage point that our foreign trade deficit will knock off the growth of our domestic demand. Even the convinced free traders – of which I am one – have to admit that the immediate effect of that will be job losses in our import-competing industries. The long-term dynamic effects of free trade may well be positive for the world economy as a whole, but that is of little consolation to retrenched workers and bankrupt companies.

The Fed's critics, and American bankers threatening to begin laying people off if the Fed does not promptly oblige with higher interest rates, should understand that there is nothing the U.S. monetary authorities can do about Asians' unrelenting quest for export-led growth, and the European chaos of mean fiscal austerity policies and biblical refugee crises. There is also nothing the Fed can do about structural problems in U.S. labor markets. Only broad and active structural policies – e.g., better and more affordable education, labor force retraining and relocation – could make more people employable in an economy which, thanks to the Fed, is already pushing well above its physical limits to growth.

Foreign trade and labor market policies are the responsibilities of the federal government.
It is not up to the Fed to negotiate better market access to American companies in foreign countries, or to make sure through various G forums (G7, G20, etc.) and multilateral organizations, such as the IMF and the OECD, that economic policies are properly coordinated in order to ensure a fair and a more balanced international trade. And neither is it the Fed's fault that East Asia and the euro area are currently running trade surpluses of $700 billion and $320 billion, respectively, and acting as a huge drag on world economy – extracting that 1 percentage-point gift from the growth of the U.S. domestic demand.

The Fed just has to compose with all that, and to calibrate its policy in order to minimize the negative
effects on U.S. growth and employment of this extremely unbalanced situation in global trade flows. The sad part is that none of these vitally important issues for American economy and security are even mentioned, let alone debated, in the presidential primaries of either party – except for some rather folkloric utterances by Donald Trump, who keeps screaming "they are robbing us blind," and who would treat the Chinese president to a Big Mac instead of a glittering state dinner at the White House.

Somebody has to mind the store. It is easy to criticize the Fed for everything, especially if the Dow does not keep soaring. But the Fed's critics have to understand that economic growth, employment creation and a sound investment environment are a result of an entire policy mix - monetary, fiscal and structural (or regulatory) policies – that is supposed to guide an open economy toward an optimal utilization of its (physical) capital and labor resources.

Having missed the September deadline for the Fed's interest rate increase, the wise-guys are now taking what they call "a December liftoff" as an obvious certainty. Investors, as opposed to traders, should pay no attention to that. People confidently predicting a September rate hike have shown that they can't even read an open book that is called the Fed. The Fed will exercise its mandate as a function of events whose outcome is unknowable ex-ante. The Fed is watching these events like the rest of us. When the data begin signaling the desirability of a policy change, the Fed will adjust its instruments in a manner that will carefully prepare its next move.

So far, the Fed sees nothing that would warrant that kind of action.

Enough already - Get on with it!

The stabilization of Chinese markets during this last week has helped to lower volatility and ease safe haven flows into the USD and Japanese yen. The AUD was the best performing currency last week powered higher by better than expected employment data. The month of August saw 17K new jobs created, the unemployment rate easing to 6.2% from 6.3%, and with July job growth revised up. The Aussie also received some help from higher copper and iron ore prices. Surprisingly, the NZD was able to eke out a gain of 0.58% on the week despite a cut in interest rates of a quarter point to 2.75% by the central bank. The yen was the worst performer thanks to China’s stabilization, poor data, and political jawboning. Japan’s machine tool orders fell 3.6% on the month and producer prices fell by 3.6%. Prime Minister Abe’s economic advisor, Kozo Yamamoto, created a firestorm when he said that the Bank of Japan should expand its monetary easing program by at least 10 trillion yen at its October 30th policy meeting. Yamamoto said reaching the bank’s 2% inflation target in the first half of the fiscal year beginning April 2016 is an "absolute imperative".

All eyes will be on the Federal Reserve this week as they decide whether to increase interest rates for the first time in 9 years at its September 17th policy meeting. Last week, Fed Chair Yellen’s favorite jobs indicator, the US JOLTS data, showed a large jump in total job opening though hires lagged behind (for sixth month). However, the state of the U.S. economy hasn’t been the focal point for a rate hike since early August. The Fed was edging closer towards a hike at their September meeting before China devalued their currency, which caused equity markets around the world to destabilize spurring wild volatility and tightening of financial market conditions.

Well, we’re finally here. The stage has been set. The issues for and against a rate hike have been debated ad nauseam. The uncertainty of all of this has become unbearable – enough already and get on with it! Whatever the decision is, it will most certainly cause volatility to ramp up. A hike will deepen the fear of a global deflationary spiral caused by a stronger USD and/or a Chinese hard landing. Standing pat will keep the threat of such a hike ongoing into each subsequent meeting in October and December.

The U.S. dollar index has limped into the end of the week. Its technical condition is tenuous at best with the momentum indicators all pointing lower while it sits just about its 200-day moving average. It looks set to continue its sell off until the FOMC decision.

You’ve probably asked yourself what’s the big deal about a quarter point hike in interest rates when the fed funds rate is near between 0 and 25 bps. Well, if the Fed hikes by 25 bps then interest rates have effectively gone up by 100%. This alone has the ability to cause ripple effects across the derivative world of interest rate contracts which in turn has the ability to cause interbank credit risk. This is why the TED (TED spread definition) spread has been moving higher since China's devaluation. According to Head of Global Investment Research for Alhambra Investment Partners, Jeffrey Snider, the TED spread is now where it was in the weeks just following the flash crash of May 2010 and equal to October 2011, after the SNB pegged the CHF to the euro and the Fed reproduced dollar swaps globally.

And we're off to the races

We want to bring to your attention something we believe has yet to be priced into the markets regarding the Canadian dollar. The CAD was able to claw back most of last week’s losses on the back of a rise in non-energy exports and pretty healthy jobs report. However, the market has been complacent about the possibility of a change in government on the October 19th federal election. Current poles show that it is a three way race with the left-leaning New Democratic Party (NDP) enjoying a narrow lead. The NDP’s platform includes an extensive social agenda and the imposition of a cap-and-trade system for carbon emissions, which could endanger the drive to a balanced budget and a potential threat to energy investment, at a time when the sector is already under tremendous pressure.

Thus, if the NDP continues to rise in the polls then international investors could start to worry, which could weigh heavily on the CAD. Furthermore, this past Wednesday the Bank of Canada decided to stand pat at the policy meeting in order to stay politically neutral ahead of the federal election. However, the BOC may be forced to cut the benchmark interest rate at the October policy meeting after the election if oil prices are below the BOC’s own forecast and if domestic data continues to weaken.

The key event next week is Thursday's U.S. Fed interest rate announcement. There is about a 30% probability of the first Fed rate hike since June of 2006. Stay tuned for both Canadian and U.S. retail sales and inflation data reports which will be announced before the FOMC committee meeting.

The Greatest Show on Earth

Wow, what a volatile week in the markets! Black Monday 2015 kicked off violent moves in stocks and currencies. Stock markets managed to recover all of its losses and even finished the week higher in some cases. Unfortunately, that can’t be said about the currency markets as the yen and the USD outperformed the rest of the field as panic caused wild swings in currencies. The Americans pointed the figure at the Chinese for the cause of the sell off – the Chinese government failed attempt to support their equity markets followed by an unexpected devaluation of their currency. The Chinese retort was that stocks have moved sideways since the US Fed stopped QE in November and that the speculation around the Fed’s next move finally hit caused a panic. Who’s right? We happen to think that both sides are correct. Volatility always occurs at the end of a trend and the beginning of a new one. Market participants are nervous because of the two powerful and opposing threats to growth and stability – the risk of a deflationary slump if China buckles and the emerging market crisis turns systemic; versus the risk that central banks could fall behind the curve and leave too much stimulus in their own economies.

We think that most of you are by now familiar with the market turbulence caused by the threat of an interest rate hike by the U.S. Federal Reserve. The prospect of the Fed’s first rate hike since 2006 has fuelled growing fear of renewed volatility in emerging economies’ currency, bond, and stock markets. The concern is that rising interest rates will lead to a rising USD which will wreak havoc among emerging markets’ governments, financial institutions, corporations, and even households because they all have borrowed trillions of USDs and rising interest rates and a rising USD will cause debt servicing costs to rise.

Now imagine the pressure on currencies of oil producing countries. Most of these countries peg their local currency to the USD and plummeting oil prices are straining government budgets. Earlier this month, Kazakhstan decided to give up its peg and switched to a free float. This move caused Kazakhstan’s tenge to plunge a record 23% in one day, but it freed it from burning through its reserves in order to prop up its currency. Kazakhstan’s Prime Minister Karim Massimov told Bloomberg that in the new era of low oil prices “most of the oil-producing countries will go into the free-floating regime, including Saudi Arabia and the United Arab Emirates.” Indeed, expectations have grown after Fitch cut Saudi Arabia’s outlook to negative from stable last Friday. Fitch noted that the twin fiscal shocks of lower oil prices and increased spending under new Saudi King Salman bin Abdulaziz al-Saud will cause the budget deficit to widen to 14.4% of GDP this year. The budget is sure to rise on news that Saudi Arabia invaded Yemen on Friday.

With government budgets of emerging markets and oil producers under stress, these countries have had to rely on the selling of their reserves mainly by way of selling US Treasury’s. Speaking of selling Treasury’s, according to Societé Generale SA, the central bank of China has likely sold somewhere on the order of $100 billion in US Treasury’s in the past two weeks alone in open FX operations in order to slow down the fall of the yuan after it devalued its currency earlier in the month.

On the surface, this seems harmless. But in reality, it is a major headache for the USD and the U.S. with multiple ramifications. First, if these countries are selling US Treasury’s then they are not buying. This begs the question of who will step in to fund U.S. deficits? Second, the selling alone could cause yields to increase. If yields break above the trend line on the chart of 10-Year US Treasury yield it would signal that major central bank selling is overwhelming the buyers. This would cause the Fed to ease. Ironic isn’t it? A Fed rate hike would increase the stress on emerging market and oil producing countries, which in turn would cause them to tap their reserves by selling US Treasury’s, causing bond yields to rise and triggering a monetary policy reversal by the Fed, possibly in the form of QE4.

We Are Asking Too Much of the Federal Reserve

A well written article is making the rounds in the blogosphere of financial and political pages alike by Robert Kuttner who is co-founder and co-editor of ‘The American Prospect'. It’s worth a read and re-printed below.

There has been obsessive chatter about whether the Federal Reserve will, or should, raise interest rates this fall. At the Fed's annual end-of-summer gabfest at Jackson Hole, Wyoming, the issue was topic A. Advocates of a rate hike make the following claims:
Very low rates were necessary when the economy was deep in recession. Now, with growth up and unemployment down, the near-zero rates are creating speculative bubbles. They are not really stimulating the economy much, as corporations put cash into stock buybacks and bankers park spare money at the Fed itself. So, let's get on with a more normal borrowing rate.

Opponents of a rate hike counter that the economy is a lot weaker than it looks. Wages are going nowhere. A lot of the jobs that have pushed down the nominal employment rate are lousy jobs. China's economy has just hit a big wall, which will slow down global growth.

Raising rates will increase consumer and business costs across the economy – everything from home mortgages to credit cards to construction loans. There will come a time to raise rates, but we are not there yet. If anything, the Fed should find new ways to get money out into the real economy.

The Fed is famous for raising rates prematurely, seeing ghosts of inflation. But there is no inflation on the horizon -- the bigger worry is deflation. In fact, the inflation rate is well below the Fed's own target of two percent. And the Fed is the only game in town. On balance, I think the opponents of a rate hike have the better argument. But consider for a moment that last assumption -- that the Fed is the only game in town.

The larger issue, which is getting submerged in the great debate about raising rates, is that the Fed should not be the only game in town.

Normally, in a soft economy, the government would be using fiscal as well as monetary policy. But because of the obsession with deficit reduction -- unfortunately shared by the Obama Administration (remember the Bowles-Simpson Commission?) – fiscal stimulus today is off the table; worse, deficit-reduction is contractionary. In plain English, prolonged deficit-cutting slows down growth.

It's Official: Canada is in Recession

It’s Official: Canada is in Recession

From Business Insider:

Canadian gross domestic product unexpectedly fell 0.2% in May. This was worse than the 0.0% expected by economists.

"The economy has contracted in six out of the last seven months," BNP's Derek Lindsay noted. The resource-rich economy has felt the crushing pain of falling commodity prices as global demand for raw materials has decelerated. And relief doesn't seem to be coming anytime soon.
"We continue to see falling commodities prices weighing heavily on the economy, with mining, utilities, and manufacturing presenting biggest drags on the goods side," Lindsay said. And this probably means more easy monetary policy.

"The Bank of Canada is likely to read this report as supportive of their move to cut rates at their last policy meeting earlier this month," Lindsay added. "We expect further easing ahead, as investment and exports remain in contractionary territory and the economy remains vulnerable to a correction in housing and a pullback in spending due to high levels of household debt."

Here are the specific details from Stancan:

Manufacturing output contracts

Manufacturing output contracted 1.7% in May, following no growth in April.
Durable-goods manufacturing fell 2.4% in May, as almost all major groups lost ground. Notable declines were recorded in machinery, computer and electronic products, fabricated metal products and miscellaneous manufacturing. Non-metallic mineral products manufacturing was up.
Non-durable goods manufacturing was down 0.7% in May, primarily because of declines in the manufacturing of food as well as beverage and tobacco. Decreases were also posted in textile, clothing and leather manufacturing, chemical manufacturing as well as printing and related support activities. The manufacturing of petroleum and coal products and of plastic and rubber products advanced.

Mining, quarrying, and oil and gas extraction falls again

Mining, quarrying, and oil and gas extraction fell 0.7% in May, down for a seventh consecutive month.
Oil and gas extraction fell 1.0% in May, after decreasing 3.4% in April, mainly as a result of a decline in conventional oil and natural gas extraction. Non-conventional oil extraction was also down.
Mining and quarrying (excluding oil and gas extraction) was down 0.8% in May. A decline in metallic mineral mining outweighed a gain in coal mining. Non-metallic mineral mining (which includes potash mines) was unchanged in May.
Support activities for mining and oil and gas extraction increased 2.8% in May, after rising 9.6% in April, as both drilling and rigging services advanced again. The gains in April and May followed double-digit declines in the first three months of the year.

Wholesale trade falls while retail trade rises

Following a 1.6% gain in April, wholesale trade fell 1.0% in May. Declines were notable in wholesaling of machinery, equipment and supplies, miscellaneous wholesaling (which includes agricultural supplies) as well as motor vehicle and parts wholesaling. On the other hand, food, beverage and tobacco wholesaling and farm products wholesaling were up.
Retail trade rose 0.5% in May after a 0.3% decline in April, led by increases in the activities of building material and garden equipment and supplies dealers as well as electronics and appliance stores.

Construction grows

Construction grew 1.0% in May, as engineering and repair construction as well as residential and non-residential building construction advanced.
The output of real estate agents and brokers rose 2.1% in May, up for a fourth consecutive month.
Finance and insurance sector declines
The finance and insurance sector declined 0.3% in May. A decrease in banking services outweighed increases in financial investment and insurance services.

Other industries

Utilities declined 1.4% in May, down for a third consecutive month. Electricity generation, transmission and distribution as well as natural gas distribution were both down in May. Unseasonably warm weather was recorded in some parts of the country in May.
The public sector (education, health and public administration combined) edged down 0.1% in May. Declines in educational and health care services more than offset an increase in public administration.
Accommodation and food services were up 0.9% in May, in parallel with an increase in the number of overnight travelers to Canada.

Need even more evidence?

Here are Five stages of death of the Canadian dollar according to the Globe and Mail which include Denial, Anger, Bargaining, Depression and finally Acceptance...

From BMO deputy chief economist Michael Gregory and senior economist Benjamin Reitzes:

"With a view to final trimester Fed tightening this year, unmatched by the BoC, we look for the currency to continue to depreciate, averaging C$1.33 in October [meaning about 75 cents]. Political uncertainty heading into the Oct. 19 federal election and continued global oil price volatility (but along sideways trend) should reinforce the weakening trend. Presuming the absence of post-election policy uncertainty and more oil prices, we look for the Loonie to average a cent or so stronger by 2015-end."

Other news...

The top performing currency last week was the Pound Sterling (GBP) but the excitement builds this week as we may see further gains in anticipation of the three PMI’s; Construction, Manufacturing and Services. In addition, it will be the first time the Bank of England will simultaneously release its policy decision, the meeting minutes, the votes and their new macroeconomic forecasts. Early last month BoE Governor, Mark Carney, had stated that, “the British economy's strong momentum meant the decision on when to raise rates would come into sharper focus around the end of this year.” Therefore, there is a strong possibility that there will be at least one vote for an interest rate hike.

The worst performer last week was the Swiss Franc (CHF). The SNB, Switzerland's central bank, reported a loss of 50.1 billion CHF on Friday due to a policy change. Per Business Insider, the bank's foreign currency reserves underwent a major devaluation when it decided to abandon a policy to cap the value of the franc against the euro earlier this year. Since the SNB had been buying Euros to maintain an exchange of 1.20 Swiss Francs to the Euro, it pushed up the value of the Franc, devaluing the recently bought Euros.

If you’re wondering why the US Federal announcement had little impact on the on the market last week, it might be because “staff projections prepared before the June 16-17 policy meeting were inadvertently included in a computer file that was posted to the Fed’s website on June 29.”
How’s that for a spoiler! The projections saw the federal-funds rate averaging 0.35% in Q4 of 2015, then rising to 1.26% in Q4 of 2016 and finally 2.12% in the fourth quarter of 2017. That’s one hike this year and potentially four next year. The actual statement however was quite lack luster, as the central bank only made small changes to its monetary policy, being very careful not to suggest when exactly they will raise interest rates this year; September or December. A September hike is the heavy favorite among banks, analysts and traders alike, but they may have missed something…

Puzzled?

Earlier this month we speculated that the Bank of Canada could cut interest rates after the negative April GDP print; and in last week’s blog post we said that we would be shocked if the BOC didn’t cut because of the string of negative data point after the disappointing April GDP report. Faced with a firestorm of recession talk, the BOC had no choice but to cut interest rates by 25bp to 0.5%. The CAD was promptly sold hard to six years lows. The price action far exceeded our expectations especially after the BOC raised the possibility of QE, if necessary, indicating that this move may not be the end of its easing campaign.

Bank of Canada Governor Stephen Poloz refrained from using the R word by stating that "real GDP is now projected to have contracted modestly in the first half of the year." The BOC also lowered its 2015 growth forecast from 1.9% to 1.1%. For 2016, it expects the economy to grow by 2.3% versus a previous forecast of 2.5%. The economy is not expected to return to full capacity until 2017. As for inflation, the underlying estimate is now 1.5% instead of 1.7%. As you might imagine, the decline in the price of crude oil was the major culprit in the adjusted forecasts.

In the press conference after the policy announcement, Governor Poloz said two things that really
stand out and didn’t seem to receive enough press. He mentioned that he was puzzled that the weaker CAD failed to improve non-energy exports. This statement struck a chord with us because two other countries have had that similar experience. The weak yen has not caused a surge in Japanese exports. Similarly, the weak euro has also not caused an increase in exports as evidenced in the recent Eurozone May trade figures which showed that exports fell 1.5%. We are not sure why this would be puzzling – after all, central banks are engaged in a currency war and no country can gain an advantage if all central banks are counter acting other bank’s moves with matching simulative monetary policy measures.

The other thing that Poloz said was that he expected the Canadian economy to be less in sync with that of the U.S. Are the economic cycles of the two nations that much out of sync? Many economists certainly think so – according to a recent survey in the Wall Street Journal, 82% of economists expect a Fed hike in September. If that is the case, the CAD is in for way more downside that anyone currently expects.

Still the One

With Greece and the Chinese stock market off the front pages, safe haven flows subsided and the monetary divergence theme reasserted itself as the driving force in the currency markets. Last week, the GBP was the top performer as positive economic data, including accelerating employment earnings, and a chorus of Bank of England members sounding more hawkish about a rate hike. This caused the timing of a UK rate hike to move from Q2 2016 to Q1. Having said this, the U.S. is still the one. No, we are not referring to the 70s soft rock ballad by Orleans but rather the only major central bank that is on course to raise interest rates in 2015. Federal Reserve Chairwomen Janet Yellen was on Capitol Hill last week and she stuck with her script by reaffirming that the central bank was on track to raise interest rates this year. If you remember, this is the very same driving force that prevailed in January of this year as the rate hikers were the top performers while the rest of the countries were moving in the opposite direction.

Apart from the central banks of the US and UK, the other major central banks have either a neutral bias or are in easing mode. The ECB left its policy unchanged at last week’s meeting and reaffirmed that the conditions of low inflation remain. Thus, its policy of bond purchase will remain in place. The Bank of Japan also had its meeting last week and it adjusted its inflation forecast – it no longer expects to hit its inflation target until after 2018 which means that it may need to apply more stimuli in meetings to come.

China reported a slew of key economic indicators last week, including Q2 GDP. It announced that its quarterly GDP came in right on target at 7%, like it always does. However, this time the chorus of investors responding with disbelief was louder than ever. No one believes their data anymore. Leaving this aside, China will probably need to administer more stimulus but more importantly their economy is not growing like it was, which is putting tremendous pressure on commodity prices and the economies of the countries that produce them – Australia, New Zealand, and Canada. Australia was the best performer of the countries in easing mode mainly because their next central bank meeting isn’t until the beginning of August. New Zealand was the worst performer because their next central bank meeting is next Wednesday; and after last week’s disastrous dairy auction, the odds have increased dramatically that the RBNZ will cut rates by 50 bps instead of 25 bps.

Tony Valente
Fred Maurer

More Cowbell?

Surprisingly, the biggest story of the week wasn’t Greece but the USD and the Fed. Federal Reserve Chairwoman Janet Yellen emerged from a two day policy meeting to declare that the FED NEEDS “MORE DECISIVE EVIDENCE”. More cowbell? Are you kidding?! It seems that every time the market’s perception gets closer to thinking the Fed is about ready to finally raise interest rates the Fed pulls the rug out from underneath that train of thought. After more than 6 years of emergency monetary policy, which included QE1, QE2, QElite, QE3 – all under a zero interest rate policy – what is it that the Fed is fearing?

The USD took it on the chin (more on this later) as it appears the market has lost complete faith in the Fed. For example, let’s take a look at the Fed’s revised growth rate for 2015. It downgraded 2015 GDP to 1.8-2.0% from 2.3-2.7%, which had already been downgraded in March. Doing the math, Q1 came in at 0.7% and the Atlanta Fed GDP Now model has Q2 at 1.9%. Thus, to get to 2.7% for the year means that both Q3 and Q4 must come in at 4%. This may be a tall order, but if it happens then we should expect the Fed to raise interest rates.

Now for the USD, the reaction after the Fed announcement was swift and fast. The US dollar index is not on firm ground on the charts. The 50-day moving average has crossed the 100-day moving average, which is known as a death cross in technical analysis. As you can guess from the name this is not a positive development, as it indicates a bear market is on the horizon. The momentum indicators are also flagging.

On the fundamental side, the America’s trading partners are heading in the opposite direction. Japan has signaled that it no longer wants a weaker yen. The UK looks to have regained its legs after the Scottish referendum, the federal election, and a central bank that appears comfortable in raising interest rates in mid-2016. Europe looks like it has escaped deflation and is slowly on track for positive growth despite its problems with Greece. As for China, it is starting to exhibit some green shoots – just last week China’s business indicator reached its highest reading in a year at 53.5 from the 49.7 it registered in May.

Salvation to Catastrophe: What might happen to Greece

We found this excellent article on Bloomberg, which we thought is worth a read. You can find the Original article here

The Greek saga has haunted policy makers for more than five years. Now talks are deadlocked, banks are on life support and time is running out. With financial doomsday drawing ever closer in Athens, everyone from creditors and investors to depositors is increasingly focusing on what's next.
Some things are clear:

 Greece owes the International Monetary Fund about $1.7 billion this month.

 In July and August, the European Central Bank is due almost 6.8 billion euros ($7.6 billion).

 The euro-area backed bailout program expires on June 30, with creditors refusing to release up to 7.2 billion euros in remaining funds before Athens complies with belt-tightening conditions.

With time running out to close a deal, the German government has begun planning for a Greek default, according to Bild newspaper. If you're waiting for a clear resolution to the country's status in the 19-nation monetary union, you may wait a long time. Adopting the euro was always supposed to be a one-way ticket, so there is no legal precedent or political roadmap for an exit.
Next steps for Greece range from retaining the euro to catastrophic divorce. Half-measures are also on the cards, such as having multiple currencies circulate, with aid recycled to repay foreign-currency debts. Equally unclear is who would tell the world - and how - that Greece has entered an economic afterlife. Possible messengers include Greek Prime Minister Alexis Tsipras, European Central Bank President Mario Draghi, European Union President Donald Tusk and European Commission President Jean-Claude Juncker. There could be others.
We asked economists, investors and former policy makers what could happen next – and how it might unfold.

Scenario A – Grexit Avoided

Tsipras, whose Syriza party won January elections promising to undo the tough terms of the bailout loans, capitulates to creditor demands. Faced with a choice between effective expulsion from the euro area or implementing austerity in exchange for loans, Tsipras takes the cash. The ECB maintains its support of the financial system.
While aid flows, the government's days are numbered as its most hardline supporters mutiny. A new coalition is formed with backing from the pro-European opposition and Syriza's moderate flank – or elections are called. Greece's continued euro membership is ultimately secured as new loans are used to repay the ECB and the IMF and the country's coffers are replenished. Greece gets easier repayment terms on bailout loans. This helps tame the popular backlash against the new wave of fiscal measures. However, the cuts attached to the agreement suppress economic output, delaying Greece's recovery from the longest recession on record.

Scenario B – Hotel California

Greek Finance Minister Yanis Varoufakis has described euro membership by using a lyric from the famous 1976 Eagles song: “You can check out any time you like, but you can never leave.” Tsipras might fail to strike a compromise acceptable to the German government, Communist factions of his Syriza party, and stakeholders in between. Somehow, though, he manages to keep Greece officially in the euro.
Bailout loans – Greece's only source of funding – remain stalled. With Europe's political leaders unwilling to proceed, the ECB rations Emergency Liquidity Assistance, the lifeline keeping Greek banks afloat.
That requires the imposition of capital controls – as there isn't enough cash to meet demand – following a bank holiday. We're calling the two possible outcomes from here “somersault” and “check out.”
Scenario B1 – Somersault
Capital controls mean that limits are placed on withdrawals and transfers. The dramatic consequences force Tsipras to compromise. Opinion polls show that most Greeks – between two-thirds and three-quarters of the population – want to stay in the euro area “at any cost”. “You can check out any time you like, but you can never leave.”
Tsipras forges a new coalition with opposition lawmakers of pro-European parties. A referendum carried out amid capital controls and with banks shut, gives him a mandate to reverse course. A unity government is formed and Greece remains in the euro, but not before the disruption triggers a new recession.

Scenario B2 – Checking Out

With banks shut, the political situation deteriorates and a popular uprising intensifies, with Germany targeted as the country's main antagonist. Polls show a swing in favor of breaking from the euro area.
Capital controls give the government the space and time to print either a new currency or IOUs for domestic payments. The new scrip quickly plunges, reflecting the weak fundamentals of an economy that has shrunk by about a quarter since 2008.

Euro-area governments give Greece a “sweetener,” a parting-loan in hard currency. The rationale is to avert total economic collapse, which would create a failed state in a strategically critical region.
Greece’s debt to public entities is restructured, providing for the repayment of loans to the IMF, either through the euro area’s crisis fund or from the departure credit. Greece remains shut out of debt markets. Most Greek companies and banks default. Some bank deposits are seized to recapitalize a shattered financial system, or redenominated to the new legal tender equivalent. The sovereign debt
restructuring of 2012 has already ensured that the state won’t have to pay principal on most of itsexisting loans to private investors and the euro area for the next few years and until the economy stabilizes. Both the new paper and euros circulate. Greece may not officially leave the euro zone – the door is open to a return in good standing – though the country sputters in a financial purgatory.

Scenario C – ‘C’ for Catastrophe

Greece separates from the euro area in a messy default, amid demonstrations and deepening misery for most, with the government blaming everything on the Germans. No help is provided to support a new currency and to keep servicing bonds and IMF debt. That triggers cross-default clauses to all creditors. The government and banks collapse, meaning that years will be needed before a new structure emerges. Greece's economy plunges into a second depression. The blow from the biggest default in the history of capitalism drives Europe back into a recession and heaps pressure on vulnerable euro countries such as Italy.

Bad blood leads to Greece’s departure from the European Union. The idea that the euro is irreversible is thrown into question, rattling global markets. The economic implosion paves the way for extremists, from either the left or the far right, to take power. Those who can, flee the country. The tumult casts doubt on Greek membership in NATO. A new – and unstable – government turns to Russia for support, providing a Mediterranean outpost for Vladimir Putin.

Position Adjustment - Euro was the top performer last week, US keeps interest rates at its current level and this Friday's April US non-farm jobs report will be in focus

What a week! The euro was the top performer on the week with a gain of over 3% and at one point moved a whole four euros against the USD. Technically, the euro rally may have run its course giving up almost a full euro on Friday and after having met the 61.8% Fibonacci retracement and coming within a whisker of its 100-day moving average. The price action in the euro last week caused clients, with euro exposure to their business, to call us with questions about what was happening. The simplest explanation is positioning. The euro has been the most heavily shorted currency in the futures market for some time now, so when everyone in the boat is leaning one way and a big wave hits the boat the result is that the wave redistributes the weight (position adjustment). Thus, the big move in the euro was due to a short squeeze as speculators bought the euro in order to exit their short trade and not due to a fundamental change in the prospects in the Eurozone.

 

The catalyst for the move was a combination of a poor reading for Q1 GDP and the FOMC announcement. The US Federal Reserve, as expected, kept interest rates at its current level, but offered little hints on the timing of its first rate hike in nearly a decade. What the Fed did do was to remove all calendar references on a potential window for raising its benchmark Fed Funds Rate making very clear that rate decision will be a data driven. Furthermore, the Fed said it will take into account labor market conditions, inflationary pressures, and expectations of international financial developments when it decides on the timing of a rate increase.

 

 

The latest reading of Q1 US GDP came in at 0.2% which essentially demonstrates that the economy stagnated in Q1, or to sugar coat it, the economy grew very, very, very slowly. This was a huge deceleration from the Q4 2014 when real GDP gained 2.2%. Economists on average were anticipating growth of 1% in Q1. How bad was it? Well, if it wasn’t for the biggest inventory build in history, which grew by $121.9 billion and merely remained flat, US Q1 GDP would not be 0.2%, but would be -2.6%.

 

Just like a year ago, many economists and investors are pointing to snowy winter weather as the root of the weakness. Other factors holding back growth this time around may have included the strong USD, pressure on the energy sector from lower oil prices, and dock worker strikes on the West Coast that disrupted that flow of trade. All of these excuses are what the Fed calls "transitory factors". Therefore, as long as inflation keeps moving to the Fed’s target and that the economy sees further improvement in the labor market then the Fed will be looking for an opportunity to raise interest rates. Having said this, this Friday’s April non-farm jobs report will be in focus. A strong report will keep a June rate hike as a possibility. A weak report would not only rule out a June rate hike, but would put into question a move in September as well.

 

 

The technical condition of the US dollar index is on much firmer ground after last week’s price action. The index has found support near the 50% Fibonacci retracement, the 100-day moving average, and the shelf of support which was carved out from mid-January to the end of February.

 

Furthermore, the RSI has turned up, the MACD looks to be making a bottom, and the full stochastics have crossed and turned up. The technical foot print makes us wonder if the chart is forecasting a good jobs number and thus a turn in the economic data, which dovetails nicely with the Fed’s transitory factors and the beginning of warmer weather.

 

 

 

Patience is out the window

Last week the US Federal Reserve removed the word "patience" from their statement with regards to interest rate hikes in the future indicating that they may raise rates sooner than expected. However, they also leave in caveat to further evaluate the economic conditions that let that guide their policy "Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

Since the announcement the US dollar has lost 2-3% against many of the major currencies contrary the fact the interest rates may rise. What does this mean? Has the market lost faith in the FED guiding policy to an improved economy? One interesting thing to consider is that 90% of the economists surveyed by Bloomberg assumed that the FED would remove "patience" from their policy. So, even though the consensus anticipated the change, the currency market still had some of the most volatility since the "fat finger" flash crash in 2010. Furthermore, much of the fundamental economic data out of the United States is more promising that many of the major currencies that it lost ground to.

 

 

 

EUR/USD finally had some relief from the free fall of the last few months and hit a high of over 1.10 while settling back to 1.0650 before the week ended. The Yen dropped to a three week low at 119.80 while the USD/CHF fell almost 3% (0.9750). That said, the CHF has been so strong as of late, luxury Swiss watch marker Tag Heuer had to drop or freeze prices in many markets to help consumers endure the relative weakness of their currencies.

 

 

 

Curve Ball - Central bank heads of the U.S and Canada were at the podium last week

Last week the central bank heads of the U.S. and Canada were at the podium – Federal Reserve Chair Janet Yellen spoke at the semi-annual testimony to the Senate banking committee in Washington while Bank of Canada Governor Stephen Poloz delivered a speech in London, Ontario about "reinventing central banking". Unlike Yellen’s testimony, Poloz threw us a curve ball. The market was leaning heavily for another interest rate cut by the Bank of Canada at its March 4th policy meeting (didn't happen). However, those hopes were dashed when Poloz said "the downside risk insurance from the interest rate cut (in January) buys us some time to see how the economy actually responds." The CAD soared as the odds of a 25 basis point cut next week were cut from 72% to 38%. Poloz had been expected to sound a "dovish" tone but his curve ball put the central bank in wait-and-see mode.

　

Meanwhile, Yellen’s testimony was interpreted as dovish by the market even though we thought that she clarified the path to the Fed’s first interest rate hike since the 2008 credit crisis. Since the January FOMC meeting the market had come to understand that once the FOMC dropped or diluted the word "patience" from its policy statement that it could expect the Fed to raise rates after two meetings. In her testimony, Yellen further clarified this notion by saying that a rate hike could occur at any meeting after the forward guidance changed. We personally see this as a bullish development, but the market has read it as a dovish development. Most media outlets conveyed that this meant that once the word "patience" was removed that the Fed would become data dependent – duh! When hasn’t the Fed been data dependent? There is nothing new here; it will come down to a change in forward guidance and the next opportunity for the Fed to do that will be on March 18th. Thus, once patience is dropped, the count down for a rate hike will begin.

 

 

The USD has already gained considerable ground against a broad cross-section of other currencies, propelled by relatively strong U.S. growth and the divergent direction of monetary policy guidance from the Fed and the policy outlook for many other central banks. Now that the Fed has laid down the framework for a rate hike all data will be scrutinized as to whether it is positive or negative for a rate hike. Therefore, the USD is vulnerable to poor economic data and will move higher on good economic data. We had our first test last Thursday with the January CPI reading. Media headlines proclaimed that deflation had come to America with consumer prices falling by 0.1%. The decline in prices was almost all due to falling gas prices.

So this begs the question – can the Fed raise interest rates in the face of falling prices? We believe Yellen has already answered this question and took the opportunity to reiterate her position on this in her testimony by stating that the inflation impact from falling energy prices was temporary. We suspect that the plot will have a few more twists and turns with a busy data week ahead with US ISM manufacturing PMI and the non-farm payroll data.